Doug Short: Three Market Valuation Indicators

In anticipation of the government's release on Thursday of the latest Flow of Funds data, which is used to calculate the Q ratio, I've been tinkering with improvements to my overlay chart of the three long-term indicators of market valuation.

• The relationship of the S&P Composite to a regression trendline (more)
• The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
• The Q Ratio — the total price of the market divided by its replacement cost (more)

The chart below differs from my previous version in two ways:

First, to facilitate comparisons, I've adjusted the Q Ratio and P/E10 to their arithmetic mean, which I represent as zero. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I'm using as a surrogate for fair value. Based on the monthly averages of daily closes in the S&P 500 for the month of May (1125.06), the index is overvalued by 26%, 33% or 39%, depending on which of the three metrics you choose.

Second, I changed the S&P regression data from a line to an area chart. This change is primarily intended to make the chart a bit easier to read, but it also reinforces the difference between the two line charts — both being simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart (see this regular feature for more explanation).

Click for a larger image

The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the "average"). The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers. In my view, the first chart does a satisfactory job of illustrating these three approaches to market valuation, but I've included the geometric variant as an interesting alternative view for P/E and Q.

Click for a larger image

I'll be updating these charts later in the week when the Federal Reserve Board releases the latest Flow of Funds data, which is used to calculate the Q ratio.

(c) Doug Short